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In real estate, capital planning is the practice of allocating capital over the anticipated hold of an asset. Inextricably tied to an owner’s overall business strategy, the capital plan is a guide and roadmap for the investment, and a reflection of the owner’s strategic priorities.
A good capital plan prioritizes which projects should be undertaken, when they should be completed, how they will create value and how much they should cost. They also track which projects have been completed, how much those projects cost and how the project execution differed from the original plan.
Capital plans are key tools for reporting to both internal team members, external parties and important partners. Ideally, well-constructed plans keep a company accountable to the following stakeholders:
• The capital providers who supply funding
• The acquisitions team that buys the asset
• The asset management team charged with managing the investment
• The property and project management teams responsible for executing the work
• The accounting team overseeing the distribution of funds
DEFINING OUR TERMS
The terms capital planning and capital budgeting are often mistaken for each other so let’s clarify:
Capital planning is the long-term allocation of capital—typically over at least a period of five years—that includes a list of projects often categorized by type or priority.
Capital budgeting is the allocation of capital for near-term projects—most commonly in the next 12 months—that usually includes more detailed cost estimates and a breakdown of spend by month.
How Do Real Estate Owners Use Capital Plans?
Capital planning is an intensive process involving a cross-section of participants and can take months to complete just the initial strategy for a property. So why do good owners invest so many resources into the endeavor? Because capital plans serve a wide range of purposes that are critical to maintaining a healthy real estate portfolio.
A TALE OF TWO IMAGINARY COMPANIES: SO-SO HOLDINGS & STEADFAST CAPITAL
As you can probably tell by their name, So-So Holdings is not the star of the real estate industry. They can be best described as reactionary. They have good intentions, reasonable investment goals and solid skills, but they don’t have a sufficient grasp on what’s happening in their portfolio. Whether it’s because they’re too busy putting out fires or they’re just doing things the way they’ve always been done, So-So Holdings doesn’t spend time planning ahead or improving their collaboration or reporting processes. As a result, they often find themselves surprised by unanticipated events at their properties.
Steadfast Capital, on the other hand, is nimble and proficient. They don’t have more resources than So-So Capital; they’re simply more consistent planners who are meticulous about gathering and leveraging their portfolio data. Decision-makers from across their company, from the asset managers to property managers, meet on a regular basis to unpack what has happened in their properties and make informed decisions about what will happen in the future. Steadfast Capital believes that many seemingly ‘unanticipated’ events can actually be spotted and averted when their teams understand what’s happening in real-time.
Let’s put it this way, So-So Holdings probably has a full case of diet Coke sitting inexplicably beside a cold fridge whereas Steadfast Holdings probably keeps spare umbrellas—branded with their logo—by the front desk just in case there’s an unexpected shower.
Now, let’s take a look at the five most important applications of capital plans.
MANAGING CAPITAL REQUIREMENTS
First and foremost, real estate owners need to keep their companies solvent. (“Genius!” you say. “Where can I invest?” you exclaim. Bear with us, we promise we’re going somewhere.) Having good, real-time insight into when and where capital is being deployed is critical.
Let’s look at how this could be managed poorly and how it could be managed well using our fictitious real estate companies as examples.
Unsurprisingly, So-So Holdings doesn’t have a thorough capital planning process and they only revise, or reforecast, their plans once a year. When an unexpected project suddenly pops up that needs to be done next year, like a structural roof problem, they’re unprepared. The accounting and capital teams are only notified about this issue during the annual budgeting process when they determine that they don’t have enough money to complete the job. They’ll have to reduce the scope on other projects or push other jobs out entirely to fund this work.
Steadfast Capital reforecasts its plan every month. Some months, they simply update the existing plan with new information; other months they convene a larger group of stakeholders to conduct a deeper dive into projections. This keeps them abreast of their actual short-term capital needs. When an emergency project comes up, they’re able to work with their capital providers to secure additional funding or thoughtfully reschedule another project in order to better manage their cash position.
MANAGING LARGE SWINGS IN CASH FLOW
While rent and operating expenses are fairly recurring in nature, capital expenses can result in large swings in cash flow. This activity has to be managed incredibly closely to ensure the property remains solvent.
Projects like major lobby renovations, roof replacements and elevator refurbishments are costly and may require more cash to fund them than regular levels of operating cash at the property could cover. With a good capital plan, these investments can be seen in context with all the other investments occurring at that building and allow the asset manager to push and pull other projects in order to ensure they have sufficient cash to cover everything.
As we know, Steadfast Capital manages their capital plan diligently and reforecasts monthly. This allows them to better manage the inputs of their valuation models, helping them report on changes to returns, like unrealized gains or losses, more quickly to their investors. Additionally, because their models are more timely and more accurate, they’re able to build trust with their investors regardless of good or bad news.
Since So-So Holdings only reforecasts their capital plans once a year, their valuation models are less accurate. Their overall returns may vary significantly from investor expectations. This will obviously diminish trust in the company and some investors may decide to take their money elsewhere, like straight to Steadfast (who will gladly woo them with reliable returns and lavish umbrellas).
CAPITAL PLANS & VALUATION MODELS
Capital plans are important components of valuation reports. Valuations are the process through which real estate companies measure how much a property is currently worth and determine what their returns will be based on the current assumptions.
Valuation models take into account a lot of information that exists outside the capital plan, for instance revenue (usually in the form of rent), and other expenses, like leasing costs and insurance. A discount rate is usually applied to all the yearly cash flows and a current net present value is determined. Since capital projects are often large they can create spikes and troughs in yearly cash flows. The accuracy of a capital plan can therefore have meaningful implications for value and returns.
Plus, valuations are usually reported on at least a quarterly basis, and are especially important for large institutional investors who are required to report on this to all their investors. Reforecasting monthly, or at least quarterly, while enabling the capital plan to contribute positively to the valuations process instead of slowing it down.
ASSISTING IN SELLING THE ASSET
During the disposition process, which is a fancy term for selling a building, having a full view into accurate capital costs makes it easier for the sell team to market the property and close the deal.
When Steadfast Capital tries to sell a building, they can use their thorough and current capital plans to accurately tell prospective buyers how much work has been done. With a complete picture of the value-add work that was undertaken, they can raise more interest— and possibly the price. Steadfast may be able to sell the property quicker since they have this information at the ready during the due diligence period. Additionally, their access to actual pricing data on open projects may put them in a better position to negotiate with the buyer.
Thanks to So-So Holdings insufficient planning process, they don’t have access to accurate data on how much money was spent on the property. They’re not able to market the work they completed in the building and they have to scramble to collect this information during the time-sensitive due diligence period. In the end, this may result in a lower sales price.
Additionally, all projects that are currently in flight must be accounted for which means tracking down all contracts that haven’t yet been paid. If there are projects underway that the seller is going to have to manage, they’ll usually get a credit for the amount of remaining work against the sales price. Steadfast Capital will be able to gather this information quickly, but So-So Holdings will have a difficult time and it may cost them money on the sale.
REPORTING TO INVESTORS AND PARTNERS
The importance of reporting to investors and partners can’t be underestimated. For one thing, a capital plan the main document of record for how things are going at the building as it relates to capital expenses. Since joint venture partners typically have approval rights on the plan, they’ll want a clear and accurate status report of how those expense are lining up.
Secondly, organizations that are known for their professionalism and accuracy are more likely to be courted by other top flight organizations or capital partners. At the end of the day, if anyone is going to place a significant amount of money in the trust of someone else, they’ll expect transparency into how their money will be spent plus regular progress updates.
The Typical Capital Planning Process
CREATING THE INITIAL PLAN
Commercial real estate owners usually initiate the capital planning process when they’re considering buying a new asset. At this point, the acquisitions team puts together a rough plan with the help of the operations team or an outside consultant.
This first iteration of the capital plan is often made in a spreadsheet, but it can be as basic as a draft drawn on the back of an envelope. High-level estimates are also rough at this stage; the team may just make an educated guess as to the cost per square foot for various categories of work, like preparing vacant space, and multiply that number that by the size of the space.
When the purchase offer is actually made, the acquisitions team along with the operations team or an outside consultant uses the due diligence period to conduct a much more thorough inspection of the building. This survey usually uncovers four types of jobs that need to be undertaken:
1. Value enhancing capital projects that are selected based on the owner’s unique view on positioning the asset
2. Required capital projects, including bringing the property into compliance with the Life Safety Code and other legal requirements
3. Leasing capital projects, which includes all of the work needed to move tenants into new spaces as existing leases expire
4. Projects that are somewhere between necessary and value enhancing that act as bulwark against value loss by keeping pace with market trends, like adding amenities that comparable competitive projects offer for similar rents
If the due diligence work is undertaken internally, the operations team usually conducts a parallel process, sometimes with consultants specializing in things like elevators, roofing, windows and energy efficiency, to get a grasp on what construction projects need to be done, when and at what cost.
This initial capital planning process can happen very quickly, sometimes in a matter of days. It’s not ideal to rush, but when a lot of capital is chasing properties, building transactions often involve auctions or bidding wars. By committing to get through the due diligence period quickly, buyers can make their offer more attractive to sellers. But, owners need to make sure that any expedited schedule still provides time to adequately research assumptions and get good estimates.
This initial capital plan is also known as the underwriting capital plan. This plan isn’t categorically different from other versions, but it is the first official capital plan and it’s the version commonly used to benchmark results against during reforecasting. As they say, “you make your money when you buy” so you’ll want to keep sight of these original projections throughout the entire time you hold the asset.
All assets undergo changing conditions, whether structural in nature, like new projects that pop up, or market based, like new leases, market upswings or downturns. Although the underwriting capital plan sets out an initial vision for the asset strategy, it’s necessary to reassess this plan on a regular basis to account for these shifts.
When you reforecast, tie revised numbers back to your original projections from the underwriting plan. Otherwise, you’ll lose your point of reference.
The frequency at which real estate owners do this varies. At the very least, most companies reforecast every six months; other teams reforecast quarterly or even monthly to bring the plan up-to-date with new spend.
The reforecasting process typically involves a number of players such as asset managers, property managers and accountants. It also includes a number of other dimensions:
• Which projects should be undertaken? Does the existing list of proposed projects make sense today? Should some be added or others removed?
• When should projects be started? Should timelines be shifted?
• How much should these projects cost? Are the cost estimates from last year still useful? Should costs be revised for projects starting in the next year or two?
As we discussed at the very beginning of this guide, capital budgeting is the process for drilling down into more detail on near-term projects. This process is usually reserved for projects that are slated to start within the the upcoming year and it entails projecting the cash flows by month.
To get updated costs, teams will ask one or two vendors to provide a conceptual estimate for the job. This provides more certainty than a “SWAG” estimate (aka, a Sophisticated Wild Ass Guess) that internal team members might make.
Monthly projected capital spends are usually also incorporated into a larger budgeting model, which includes non-capital expenses and revenue.
Why is Capital Planning So Hard?
As we see in Illustration 1, capital plans are integral to the work of a lot of people in a real estate company. They touch every point on the lifecycle of an asset, impact overall portfolio returns and create more nuanced value, like building trust with investors and partners. But they also come with a set of challenges that, well, are not insignificant, to put it diplomatically. If capital planning were easy, So-So Holdings could probably change their name because their financial outcomes would improve so much.
Here are a few of the reasons that capital planning is hard.
• It’s time consuming. Teams need to allow several weeks to a couple months to prepare a complete capital plan. When portfolios grow or when asset ownership gets more complicated with the addition of joint venture partners, even more time needs to be allocated for the process.
• It’s requires cross-team collaboration. Thorough planning requires input from most, if not all, of the different players included in the previous chart. For organizations that aren’t using purpose-built software, weeks of back-and-forth emails, cross-functional meetings and impromptu phone calls usually ensue until all of the data is collected, verified and logged.
Let’s examine this point more closely because inefficiency can be remarkably insidious. Imagine you have a real estate operation with 15 buildings across the United States. A portfolio of this size probably requires 15 property managers, five asset managers, two accountants, two members of the acquisitions team and two members of senior leadership to be involved in the capital planning process.
That’s a lot of people to review a capital plan. Except there’s a lot more than a capital plan. Look at how files proliferate if each building forecasts quarterly and, like most companies, needs to create multiple drafts before they arrive at the final version.
• It’s imprecise. Here’s a truth that’s as old as time: It’s really hard to get estimates for how much a project is going to cost and how long it will take to complete. Why? Because many companies don’t have a dedicated team of construction folks who can take the time to thoroughly think through pricing.
Outsourcing the job of cost estimation to a vendor can also lead to inaccurate projections when the person providing the estimate is not on the hook to actually deliver against it. They may low-ball the number in the hopes of getting invited to bid on the actual project later. Or, since it’s just an estimate and they’re probably not being paid for the work, they may not put that much effort into making sure it’s as correct as it could be.
Additionally, the further out you are from a project kickoff date, the less information you have to inform your estimates. Let’s say you plan to add a gym to a rental building in two years. You won’t have engaged an architect yet and you’ll only have a fuzzy idea of the scope. You don’t know what amenities it will have, how big it will need to be, whether it will have a sauna or other details. Therefore, your projections will be based on incomplete data.
In case that’s not enough, here are a few more reasons that capital planning is hard:
• It’s difficult to track changes over time and report on capital planning decisions.
• Plans created by different teams are often built in different formats making them hard to roll up and summarize.
• Capital plans created in spreadsheets can spawn new, incompatible versions as they’re passed around, making it hard to to know what the record of truth is for a building.
• Siloed data makes it hard, if not impossible, to pull up a plan with real-time information.
Capital Planning Best Practices
Capital projects impact leasing which impacts revenue. That is what “value add” means after all. New amenities, upgraded mechanical systems and renovated spaces can give a property an important edge over the competition in attracting tenants and drawing higher rents.
Capital projects can also reduce operating expenses. Investing in building systems can help reduce the cost of running a building. For instance, installing solar panels may bring down electricity costs.
CAPITAL PLANS & REAL ESTATE RETURNS
Two of the most important metrics for measuring returns are internal rates of return (IRRs) and equity multiples.
IRRs are weighted returns that are impacted by the timing of capital flows. In a simplified example, if an owner spends $2,000,000 on a property last week and sold it one day later for $3,000,000, the IRR would be higher—all other things being equal—than if that owner bought the same building for $2,000,000 and sold it for $3,000,000 a month later. However, IRRs doesn’t tell you how much money you’ve actually profited.
On the other hand, equity multiples—the cash distributions received from an investment divided by the total equity invested—ignore time but will indicate how much your investment has made or lost. In order to get a full picture of your returns, both metrics should be used.
So how can real estate owners optimize their capital planning process and, as a result, maximize portfolio returns?
IMPROVE THE HANDOFF BETWEEN THE ACQUISITIONS AND ASSET MANAGEMENT TEAMS
The acquisitions team’s main incentive is to close deals. In order to do that they need to underwrite assets in a way that makes it attractive as an investment. Sometimes, they can be a little overeager when it comes to underwriting and making assumptions that would be hard to execute.
Once the asset is purchased, they will step aside and asset managers and the operations team will be tasked with implementation. In order to make sure the needs and expectations of all of these teams are met, it’s important that they work together during the underwriting process to create and approve the initial plan.
There are three ways to make this handoff more efficient:
1. The approvals process should include members from leadership, asset, operations and
2. The teams need to communicate well and often.
3. Tying compensation for the acquisitions team to the performance of the property might
encourage them to be more realistic in underwriting.
IMPROVE THE HANDOFF BETWEEN THE ASSET MANAGEMENT AND ACCOUNTING TEAMS
The best way to improve the handoff between these two teams is simply to make sure they’re working in the same calendar format, either fiscal or calendar.
So-So Holdings’ asset management and accounting teams are not using the same calendar
format. One of their underwriting capital plans indicates $20 million of capital projects in the first year, but that plan is built on a fiscal year that runs from June to June. When the capital plan was sent to the accounting team, who work on a calendar year, they had no good way of knowing how much should be spent from June to the end of December.
If it’s not feasible to put your various teams on the same calendar format, make absolutely certain that the capital plans are broken down by month so the accounting team can prorate costs easily.
Additionally, make sure the capital plan can directly tie into the accounting team’s system. Keep in mind that some budgeting platforms include more detailed expenses that are part of capital, such as insurance and taxes.
IMPROVE THE HANDOFF BETWEEN THE PROPERTY AND ASSET MANAGEMENT TEAMS
Nobody knows the quirks of a building quite like its property management team. Where tenants hear squeaky doors and rattling windows, property managers hear a symphony of sounds that turn an ordinary building into an orchestra of life...
Ha! Just making sure you’re still with us. Property managers hate those sounds, but since they’re also painfully aware of every noiseless problem in the building, they’re one of your best resources for prioritizing projects. Asset managers should listen closely to their insights on issues at the property and check in with them during every reforecast.
This applies during the acquisition process, too. If it’s possible, the acquisitions team should get input from the existing property management team to verify and refine the underwriting plan.
LEVERAGE PAST DATA TO MAKE BETTER DECISIONS ON CURRENT CAPITAL PLANS
Many owners feel like they’re starting from square one every time they reforecast their capital plans. Historical data is a goldmine of valuable information that could alleviate some of this pain but it’s often not taken advantage of for a number of reasons:
• It’s difficult to roll up and consolidate information in a spreadsheet.
• Many files are out of date because they’re dispersed across computer desktops, shared drives and even physical binders.
• Most spreadsheets aren’t easily searchable.
However, it’s incredibly valuable to solve this problem.
Historical data can make estimating more accurate, which may mean less need for contingency, which in turn may mean that acquisitions can bid more for an asset.
Every project, as well as its corresponding line items, should be saved in a way that makes the data easily accessible. Furthermore, you should make this historical project data searchable by various filters and conditions. For example, if you’re working on a new lobby project, you should be able to search your records for all past lobby projects you’ve done, narrow that group down to jobs of comparable size, finish quality and location, and see exactly where those projects priced out. Looking at the average price or range of prices is incredibly helpful in the allocation of capital in this scenario.
ENABLE “LIVE” REFORECASTING
In an ideal world, all invoiced amounts and change orders would be automatically pulled into the same spreadsheet or project management system as your capital plan. Since a capital plan is only as accurate as its last reforecast, “live” consolidation of data can uncover potential problems much faster. As a result, large change orders will be reflected in the capital plan in real-time, without the dangerous lag that happens with teams that only reforecast periodically. If you can’t manage this in Excel, it might be worth looking into purpose-built software.
ENSURE THERE IS ALWAYS ONE—AND ONLY ONE—OFFICIAL CAPITAL PLAN AT EACH PROPERTY
There should only ever be one official capital plan, but, as we saw in Illustration 2, when you’re creating them using spreadsheets, multiple versions are often created, causing confusion as they circulate amongst the team.
Here are some tips to prevent the curse of the replicated spreadsheet:
• Designate one or two people to be responsible for creating and maintaining capital plans.
• Require that a note be added every time a revision is made, including who made the revision and when.
• Give all capital plans a standard naming convention. For example, “buildingname_year_ month_type.”
• Store clearly labeled plans in central locations, preferably in a cloud-based software so they are accessible to a range of stakeholders.
MAKE CAPITAL PLANS EASIER TO SHARE WITH EXTERNAL PARTIES AND PARTNERS
Sharing capital plans with external parties like lenders and partners is frequently a mandatory requirement of any loan or partnership agreement. However, the information that you want to share is not always the same.
This is one case when you should intentionally make another version of your master capital plan. Create a secondary file that removes unnecessary or sensitive information, and rolls up small projects into categories, like tenant improvement projects. You may also want to remove comments on the statuses of the projects.
The Power of Capital Planning Data
Your asset’s capital plan is the roadmap to its future, and consequently, your financial returns. It is forward-looking and, yet, very much connected to your portfolio’s past. At the end of the day, the real difference between companies like Steadfast Capital and So-So Holdings is how much value they place on data.
Real estate owners who are unlocking their power of data recognize that the information they have from previous projects, like pricing and timelines, empowers them to make smarter decisions about the future.
But aggregating that data in a usable way requires diligently tracking costs on current projects in real-time, standing up systems that link past and present data with future projections, and regularly reforecasting the capital plan. While there is no silver bullet to capital planning, implementing the best practices in this guide should make the process a little easier and a lot more productive.
MAKE YOUR REFORECASTING PROCESS FASTER AND MORE EFFICIENT
Honest Buildings’ capital plan solution supports ‘live’ reforecasting by making your project data accessible in real-time.
Honest Buildings is the only project management platform built for real estate owners, and backed by real estate owners. Global, national and local owners are utilizing the power of our platform’s data- driven technology to ensure capital and construction projects are completed on time and on budget.